Bernanke Is Better Than His Critics at Balancing Risks

June 26 (Bloomberg) -- The markets’ reaction to the Federal
Reserve’s latest policy announcement isn’t what Chairman Ben S.
Bernanke wanted: Long-term interest rates have gone up. That’s a
problem because the recovery is still tepid.

The message the markets received isn’t the one Bernanke
thought he was sending. What went wrong? Part of the answer is
that investors are confused -- and I can’t say I blame them.

In his June 19 news conference, Bernanke said the pace of
new asset purchases by the central bank would depend on results.
If the recovery slows, quantitative easing will continue for
longer or even be increased. He also said, yet again, that any
QE is still new stimulus -- akin, that is, to further cuts in
interest rates. (As long as the Fed’s balance sheet is growing,
the central bank is easing.)

Instead of hearing what Bernanke said about conditionality,
investors have focused on the timetable he set out if all goes
to plan: The calendar, not facts about the economy, is now
guiding policy! Instead of hearing what he said about
maintaining the Fed’s enlarged balance sheet, they judged
limited expansion against the imaginary alternative of extending
QE indefinitely: The Fed just tightened!

You can’t really fault the markets; at least one member of
the Federal Open Market Committee reached the same conclusions.
James Bullard, president of the Federal Reserve Bank of St.
Louis, says the central bank is prioritizing an arbitrary
timetable over facts and has deliberately tightened policy --
interpretations that Bernanke had expressly denied.

Single Policy

That’s a shame. Debate on the FOMC is well and good, but it
surely isn’t asking too much to demand that the committee
express one view about whether it has tightened policy. However,
a more important question arises: whether the policy,
sympathetically construed (further easing for the time being,
cautious tapering of QE as conditions allow), makes sense. I
touched on this last week.

Many of the Fed’s critics argue that QE has already gone
too far, at the risk of creating high inflation and future
financial instability. Others argue the opposite -- that QE
should be stepped up to push the economy toward faster growth.
This second group is alarmed by the recent decline in inflation
and thinks the Fed should have eased policy forcefully in
response.

Bernanke is trying to strike a balance, an approach that
true believers in both camps find intolerable. I’d say he’s
basically right.

He’s discounting the hyperinflation fears of the most
agitated QE skeptics, arguing that the Fed can reverse its
monetary stimulus when necessary. That’s correct. On the other
hand, he accepts that more QE risks future instability. That’s
also correct. Persistently low long-term interest rates -- which
QE is meant to provide -- encourage investors to take on too
much risk and “reach for yield.” That could spell trouble when
the policy eventually unwinds.

Even so, doesn’t falling inflation -- the forecast for the
Fed’s preferred measure now stands at 1.2 percent to 1.3 percent
for 2013, well below the bank’s 2 percent target -- demand more
aggressive easing? It does if it fails to turn around. But
Bernanke doesn’t disagree. He’s floated that possibility and
says he’ll act if he sees a greater risk of deflation.

Not good enough, according to some. At the moderate end,
you have economists such as Bullard who think Fed statements
should emphasize its readiness to stick with QE if inflation
stays too low. At the bolder end, you have those who argue -- in
Paul Krugman’s memorable phrase -- that the Fed should “credibly
promise to be irresponsible” and increase monetary stimulus
until expected inflation rises above the target. That would
reduce real interest rates and provide a much more powerful
boost to demand.

Deflation Risk

Though Bullard’s comments about tightening were wrong, I
agree that Bernanke should have talked more about the risk of
deflation and stressed the Fed’s determination to prevent it. He
could have done that without changing anything else he said.
However, aiming to create expectations of above-target inflation
goes way beyond this and would be far riskier.

Modern macroeconomists stress the centrality of
expectations in monetary policy. If the central bank says
something and is believed, the economy tends to fall into line.
If the Fed promises to do whatever it takes to boost demand and
is believed, demand will rise without the Fed having to do much
else. That’s the crux of the case for promising boldness in
fighting recessions. Promise to be bold, and you won’t have to
be. Promise to be timid, and you’ll end up having to be bold.

The logic is unassailable -- but one should always treat
unassailable logic with caution. The difficulty is that central
banks can’t set expectations just by issuing statements or
setting targets (for inflation, for nominal gross domestic
product or for anything else). Establishing credibility isn’t
easy. After the inflationary excesses of the 1970s, it took
years of high unemployment for central banks to prove they meant
business. It was hard to suppress inflation expectations and tie
them down firmly.

Aiming for higher-than-target inflation now would speed the
recovery. If the economy stalls, it’s an option that should be
considered, as Bloomberg View’s editors have argued. But it’s a
grave error to imagine that this is a low-risk policy.
Expectations can’t be guided easily to where the Fed would like
them to be. Just reflect on the past few days: There are almost
as many interpretations of the Fed’s intentions as there are
analysts. A different policy target and a more single-minded
FOMC could mitigate that problem but won’t ever solve it.

There is an all-or-nothing aspect to the Fed’s challenge.
The central bank would probably have to cause high inflation to
loosen the anchor it’s worked so hard to put down. There’d be a
burst of growth, but a recession might then be needed to put the
anchor back down -- and that’s to say nothing of the heightened
risk of financial instability caused by investors “reaching for
yield” in the meantime. To judge the cost of this policy, you
first have to see that expectations are disobedient, then look
beyond the recovery to the next slowdown.

Don’t believe anybody who tells you that central banking in
these circumstances is easy, or that the safest policy is the
one that looks reckless. Bernanke understands the risks -- of
too little action and of too much -- a lot better than his
critics do.